Over the last few years, both parties have worked together to reduce the deficit by more than $2.5 trillion – mostly through spending cuts, but also by raising tax rates on the wealthiest 1 percent of Americans. As a result, we are more than halfway towards the goal of $4 trillion in deficit reduction that economists say we need to stabilize our finances.
President Barack Obama
The State of the Union Address
February 12, 2013
Many years ago, a seasoned Capitol Hill professional cautioned me about giving any questionable number to a politician. Many have fly-trap minds, and once you put something in, you never can get it out. Any nuanced but only partially understood fact, like a discount-store blowtorch, could be misused with considerable ill effect at some later moment.
This bit of wisdom comes quickly to mind when one hears the current buzz about a mere $1.5 trillion of deficit reduction over ten years ending our budget woes. Some reach that number by the roughest of arithmetic; others use more sophisticated analysis, and even provide important and subtle caveats. But the number, even though it has some limited use, already has left the corral of qualification and analysis far behind.
The simple way to reach that number is the way the President did. Three years ago, Erskine Bowles and Alan Simpson characterized our fiscal plight with a calculation that $4 trillion of deficit reduction would “stabilize the debt.” As the President noted in his remarks, some have estimated subsequent budget action to have achieved $2.5 trillion of that. $4 trillion minus $2.5 trillion equals $1.5 trillion, under either OMB (Office of Management and Budget) or CBO (Congressional Budget Office) scoring.
That little inside-Washington joke is not really a joke, however. Bowles and Simpson’s $4 trillion was derivative of many complex and controversial assumptions, and was calculated at a particular time. Let’s review the numerical spreadsheet, and its even-more-subtle and important conceptual underpinnings.
First of all, any calculation relating to future budget numbers requires an economic forecast. All economic forecasts are wrong, and later revisiting will require recalculation. For example, as of early 2010, when Bowles and Simpson’s commission was getting underway, the estimate for calendar year 2012 nominal gross domestic product (GDP) was $15.969 trillion. The current estimate (and it will be re-estimated forever) is $15.692 trillion, or about 1.7 percent less. Because of that difference, revenues were lower, outlays were higher, and the ensuing deficits were larger than otherwise would be expected.
Beyond differences between anticipated and actual economic performance, the mere passage of time has its effect. The population is continuously aging, which worsens the ten-year budget “window” every time the calendar turns over.
But that is the simplest stuff. The issue is the budget problem, and the necessity is to fix it. So what exactly is the “problem,” and what does it mean to “fix” it?
The President’s number is derived from the right neighborhood. The ultimate issue is the burden of our debt. The size of the debt has meaning only when scaled by the flow of income out of which we can service it. Therefore, the most useful measure of the burden is the ratio of the debt to our GDP – lower is better, of course. The level is important, but perhaps more so is the direction of change. If the debt-to-GDP ratio is too high but is falling, we might be satisfied with our course, and choose to do nothing; but if the ratio is in bounds for the moment but is rising, and that trend appears not to be temporary, then we have work to do.
But right now, our debt relative to our GDP is too high, and it is rising. The most common standard for the solution to that problem, at least among the wonkish people, is to “stabilize the debt” – that is, to stop the ratio of the debt to the GDP from rising.
Fair enough. But what precisely does that mean? Is achieving two consecutive years with equal debt-to-GDP ratios good enough? If not, do we need more years? If so, how many? Do we care how high that stable debt-to-GDP ratio is? Or do we want to be even more rigorous, and demand that the debt-to-GDP ratio actually fall? And if so, how fast?
Obviously, this is a lot of questions and conditions. Of necessity, people have simplified. The most common “window” of budget analysis has been ten years. The most common – though admittedly arbitrary – standard for the level of the debt-to-GDP ratio is 60 percent. It was on that basis that the Bowles-Simpson Commission pronounced that the nation needed that $4 trillion of deficit reduction – to reverse the growth of the debt-to-GDP ratio, and bring it back down to 60 percent by the end of 10 years. (But note that even that degree of specificity was not sufficient to nail down a number; at the same time, the Domenici-Rivlin Debt Reduction Task Force of the Bipartisan Policy Center concluded that it would take more like $5.8 trillion to achieve the same objective. That difference was driven in part by mind-numbing differences in baselines, which could be enormous based on differing assumptions about the dispositions of the large temporary tax cuts that were largely resolved at the end of last year.)
Per the calculation above, some have taken the Bowles-Simpson $4 trillion measured requirement, subtracted the alleged $2.5 trillion of deficit reduction already enacted – ignoring differences in dates when the numbers were estimated, budget windows, terminal debt-to-GDP ratios, and every other nicety – and concluded that we need only $1.5 trillion more to get to budget heaven. Others have been more sophisticated. Richard Kogan, Robert Greenstein and Joel Friedman of the Center on Budget and Policy Priorities have run all-new computations based on the most recent CBO budget projections. They have in effect (to simplify a more complex process) assumed surgically timed and targeted budget savings precisely when needed to hold the debt-to-GDP ratio at CBO’s lowest projected level (73 percent, in 2018) for the rest of the 10-year budget window. By coincidence, that computed number comes to $1.3 trillion of policy deficit reduction, which would result in another $0.2 trillion of debt-service savings – for a total equal to the same $1.5 trillion as the simple calculation. Note, however, that this is pure coincidence; the Bowles-Simpson savings were calculated to achieve a falling debt-to-GDP ratio, hitting 60 percent in 2023, whereas the CBPP savings would hold the debt-to-GDP ratio constant, down only to 73 percent in the same year. Only the $1.5 trillion aggregate is the same; everything else of importance is different.
So, does the more analytically based CBPP number render the $1.5 trillion number a valid target for budget policy? The CBPP estimate is described accurately, and its meaning is qualified fairly in the presentation. However, I believe that many have over-interpreted and oversold it. I would go one step further and say that while I respect the work and the presentation of the authors, I disagree with their own interpretation of their work in some respects. In sum, this number, like just about any one number for the amount of savings to “stabilize the debt,” is essentially arbitrary and potentially misleading.
For what they are worth, here are my key differences with that presentation, and the $1.5 trillion number itself.
What we really care about – the real bottom line – is a complex and subjective question: Can the government of the United States of America access the credit markets in a fashion that allows the economy to function smoothly? So long as the credit markets maintain their poise, and the private sector can borrow at affordable rates, economic life can go on. The debt-to-GDP ratio is an indicator of this condition, but no particular number is definitive. The change in the debt-to-GDP ratio is suggestive, and a rising ratio cannot go on forever without the most serious consequences. Still, at any given moment, the fundamental issue is whether our creditors – actual and prospective – trust us.
That status is not driven by any precise number. It ultimately depends on what the crowd – the market – thinks. And so it is determined not only by other people’s opinions, but also by other people’s behavior. Right now, the U.S. Treasury is getting a major pass in the court of public investor opinion simply because every other nation whose paper realistically competes with ours is behaving even worse than we are. We are, as the now-familiar saying goes, “the best-looking horse in the glue factory.”
That pass that we enjoy from the markets is in one sense very good news. If the Treasury were just another sovereign borrower, we might be facing extreme pressure to reduce our deficit – pressure that could force us to raise taxes and cut spending sharply and immediately, and thereby restrain an already stumbling economy. Free of that constraint, we can provide additional purchasing power to the private sector, and help to keep the economy chugging forward.
The bad side of that good news is that we continue to accumulate large amounts of debt. So even though our mounting debt is not an urgent problem, it could become so on short notice. In this respect, we are behind the curve, and we need to catch up and get ahead.
So interest rates are at rock-bottom lows. The cost of funds is not constraining private investment in the United States – yet. But financial uncertainty surely is – and financial uncertainty comes from the outlook for the public debt down the road. One reason for that uncertainty is that our divided government cannot seem to muster the bipartisan cooperation to name a post office (should one ever be built again) after Mother Theresa without a filibuster. But the substantive reason – on which we certainly cannot muster bipartisan cooperation – is the demographic push on healthcare and retirement costs.
What would keep the markets calm? I honestly believe that the markets would cheer if – even without the $1.5 trillion of savings in the next 10 years – the Congress and the President would cooperate on reducing the growth of Social Security and Medicare costs in the following 10 years and thereafter. And realistically, any conceivable fundamental reform in those two programs will take years to achieve significant savings; it would not disrupt the current economic recovery. And only fundamental reform will yield the kind of savings we need.
My concern is that focus on near-term debt stabilization at the minimum up-front cost could lead to poor decisions. If all we need is $1.5 trillion, we could just procrastinate. It’s not much [this is a budget geek talking, you know]; maybe the economic numbers will break our way, and we won’t have to do anything at all. Or only slightly preferable: for that small amount of money, we can just shave domestic appropriations or defense a little, or maybe increase tax rates on the rich a smidge. But in reality, if we leave the big demographically driven costs rising significantly faster than the GDP, savings in the slower-growing programs merely buy time. More time would be great, if it were used to move on to the longer-term fundamental reforms that would remain essential. But if the near-term incremental savings were misinterpreted as a permanent repair, the nation would merely fall even farther behind the curve on the long-term cost drivers, while piling up still more debt in the interim. (For that reason, even the Bowles and Simpson $4 trillion could have fallen short, even given its own assumptions, if the Congress and the President did not cut the right $4 trillion.)
And let’s think about what “stabilizing the debt” at 73.1 percent of GDP really means. I know very few economists who would consider a 73.1 percent of GDP target to be prudent. And at any level, aiming policy at a constant debt-to-GDP level is a little like planning to walk on the ridge of the continental divide. If you ever miscalculate, you fall one way or the other. At a low level of debt, the consequences of bad news might be acceptable. But with a debt ratio that arguably already is excessive, there is a 50-50 chance (assuming economic and other assumptions are straight down the middle) of adverse developments sending the nation’s finances down a slope that is very slippery, and very steep. In my judgment, we should not aim for a situation that entails so much inherent risk.
The analysts at CBPP raise two valid points, which again I fear are easily oversold or overbought. One is that the rate of growth of healthcare costs has slowed in the last few years, and therefore precipitous action could prove to be overkill. Admittedly, this cost slowdown might persist. Healthcare providers might be so spooked by stories about rising costs that they voluntarily have gone on their best behavior. But experts cannot explain this slowdown, and therefore cannot confirm its staying power. Similar episodes have occurred in past recessions – 1990 is a prime example – when, apparently, people with reduced incomes simply stayed away from their doctors. Such savings will not endure.
A second argument is that policymakers do not yet know enough about how to achieve savings in health care to undertake that risk. We at CED believe that there is a market-based approach that would work. The CBPP analysts fear enacting too many specific physician- and hospital-reimbursement reductions that will in the end harm patients and reduce access. But we cannot sufficiently slow health costs with such a mass of semi-regulatory micro policies anyway. Rather, we need a fundamental restructuring of the healthcare delivery system, in Medicare and more broadly, to reorient provider incentives toward quality, affordable care. And the longer we wait, the harder the task will be – and the more public debt we will have accumulated, and will need to service in perpetuity.
There is insufficient understanding of what is at stake. Some deny any concern about the debt, or refuse to consider any rationalization of the demographically driven entitlements, or both. Some are willing to crunch the economy in the near term, or misunderstand the long-term issue, or both. Instinct and experience tell me that a focus on a specific dollar number for near-term budget savings could feed all of these misunderstandings, at the expense of sound short- and long-run policy. Thus, $1.5 trillion is to me a number that we should not insert into the fly-trap minds of politicians. We should focus on the real concerns, as subtle and judgmental as they may be.